Financial leverage
Financial leverage is the use of fixed-cost debt to magnify equity returns; when asset returns exceed the cost of debt, the surplus accrues to shareholders. It raises both expected return and financial risk.
FrameworkCapital structure theory
See it move
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Two firms each hold €100,000 of assets and earn €10,000 of operating profit. Firm A is all-equity, so its return on equity is 10%. Firm B is 60% debt-financed at 5% interest; after paying €3,000 interest, its smaller equity base earns a 17.5% return. The same leverage would equally magnify a downturn.
Where it fits
SubjectCorporate FinanceCoreTopicCapital Structure & LeverageCore
The formula
LaTeX
Variables
- Earnings before interest and tax (€)
- Annual interest expense (€)
DFL states how many percentage points EPS changes for each 1% change in EBIT.